Corporate Finance Long Term Debt Government Bond Analysis FINA 4330 Lecture 5 Ronald F. Singer Fall, 2010

Topics Covered Real and Nominal Rates of Interest The Term Structure and YTM How Interest Rate Changes Affect Bond Prices Explaining the Term Structure

Real and Nominal Rates of Interest Classical Theory of Interest Rates – Developed by Irving Fisher The real interest rate (r) tends to be relatively stable over time That means that the nominal interest rate (R) tends to move with the rate of inflation.

Term Structure and Yields The Return on US Treasury Bills and the Inflation rate ( )

Real and Nominal Interest Rates Nominal R = (1+Real r) (1 + expected inflation) -1 Real r is theoretically somewhat stable Inflation is an important variable in determining the level and movement of the Nominal Rate This theory allows us to understand the Term Structure of Interest Rates. The Term Structure tells us the cost of debt.

Last Year Yield Curve

Current Yield Curve

Present Value of a Loan The Term Structure can be reflected in using various “r” terms for different time periods, where “r’s” are nominal rates.

Empirical Term Structure WSJ Yield on “Strips” A Strip is a government bond that has had the coupon or the Principal “stripped from its payments, so the “Principal strips” is the annualized yield for a government bond that makes only one payment at maturity.

Bond valuation XYZ 5s 2010: Interest paid semiannually each May 15 and October 15 Term Structure From “Strips” Maturity YTM Six Month Rate Periods 5/09 5% 2.5% 1 11/09 6% 3.0% 2 5/10 7% 3.5% 3 11/10 8% 4.0% 4 Value: YTM?

Bond Valuation What Is the “Value” of this bond Cash Flow:

Bond Valuation What is the Value of this Bond? Given the Term Structure by “strips”, the Bond is valued as follows: Present Value of first coupon: PV(2.5%,1,50) = Present Value of second coupon: PV(3%,2,50) = Present Value of third Coupon = Present Value of Principal + Last Coupon = ,185.34

Bond Valuation Yield to Maturity: Find that annualized interest rate which makes the present value of its payments equal to its market value N = 4, PV = , PMT = 50, FV = 1000 Compute I%/YR = 3 times 2 = 6%.

Yield to Maturity Example A treasury bond expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM?

Yield to Maturity Example A $1000 treasury bond matures in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is , what is the YTM? C0C1C2C3C4C Calculate IRR = YTM = 8.5%

Procedure for a Public Debt Offering Approval from Board of Directors Registration Statement SEC studies for 20-days Final prospectus is issued Securities are sold

Indentures Registration material must include a indenture The indenture is an agreement between the issuer (firm) and a bondholders’ trustee (trust company) which is the representative of the Bondholders. Trustee’s duties – Make sure indenture is obeyed – Manage the “Sinking Fund” – Represent Bondholders in general

Bond Indenture Provisions 1. The basic terms of the bond 2. Property used as security if any 3. Details of protections Bondholders have – Protective Covenants 4. The Sinking Fund arrangements 5. The call provisions

The Basic Terms Timing and the amount of the payments to the bondholders: “The bond will pay interest at a rate of 16% of par, semiannually on each October 15 and April 15 from April 15, 2009 through April 15, The annual interest rate is 16%. On April 15, 2024 the bond will make its final interest payment and also pay the holder the par value of $1,000.

Security of the Bond Collateral Trust Bonds: Common Stock held by the company is used to pledge against the bonds. – If the firms does not pay the Bondholder, they can take the stock instead. Mortgage Securities: Bonds that have specific long term assets or property as collateral Unsecured Bonds: Bonds that don’t have any specific security are called unsecured or Debentures – The bondholders become a general obligation of the firm in default.

Protective Covenants Negative Covenants: Prohibits certain actions that the firm may take that could harm bondholders – Limit dividend payments, sale of assets or mergers (without bondholders’ permission), issue additional debt of a certain class Positive Covenants: Company agrees to take certain actions – Maintain working capital – Furnish financial statements

Sinking Fund Agreements Firm agrees to periodically repurchase the bonds at a given price (usually par), or at the market price whichever is lower. – Provides additional protection to bondholders by providing an early warning system to bondholders if the firm is in trouble – Firm has the choice of retiring the debt at market prices or at the fixed price set in the contract.

Call Provision Allows the firm to repurchase (Call) the bond at a predetermined price (the call price) prior to its maturity – The call premium is the difference between the call price and the par value of the debt – Call premium generally starts at par plus one year’s coupon and declines to zero near maturity – Call protection give the bondholder protection from a call over the early years of the Bond